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Road to enlightenment?

30 January 2015

“Extraordinary opportunities” are available for investors in the eurozone, argues European equity fund manager Stuart Mitchell.

The advent of quantitative easing (QE) in the eurozone and the victory of Syriza at the Greek elections last weekend are clearly important events, but their significance should not be mistaken. Instead of reflecting an existential challenge to the whole ‘European project’, they should, rather, be seen as milestones on the long path towards the return of the eurozone to economic normality. What is more, the end of that journey, after the seven long years since the financial crisis broke, is now easier to discern.

Integrated Europe

The challenge for policymakers in the eurozone has been to preserve the goal of a more integrated Europe; but now it is to ensure that the more profligate countries at the periphery learn to control their finances more carefully and make their corporate sectors more competitive. Why should the Germans and French underwrite the debts of countries that continue to threaten to default because local politicians did not have the stomach to push through reforms?

The arrival of QE is, in effect, an acknowledgement by ‘core Europe’ that the periphery has reformed sufficiently for the underwriting of its debt to be contemplated. The European Central Bank (ECB) will underwrite 20% of the bond purchases; a key staging post towards the full and mutual sharing of debt across the eurozone. There is growing recognition of how much the peripheral countries have done to bring their houses into order. Spain, Portugal, Ireland and Greece have endured unimaginable austerity; their economies are now growing again and running healthy current account surpluses.

The efforts made by the corporate sector in Europe have been remarkable too. Just look at the job losses and reductions in salaries at Spain’s flag carrier and largest airline, Iberia, or the deep job cuts that have been made across the eurozone’s banking industry. Even the most ostentatiously fiscally-conservative Germans seem – privately at least – much readier than before to acknowledge these developments and to underwrite the debts of the eurozone.

Olympian ascent

What about the victory of Syriza, with its rejectionist platform, in the Greek election? As we write, only one thing is certain: some amount of Greek debt will have to be forgiven. The only debate is how this is dressed up. We are probably somewhere near the point where Syriza’s demands can be accepted and the Greek recovery – which, of course, is already under way – will be allowed to continue.

With the European Investment Bank now proposing to sponsor €315 billion of infrastructure spending, we are getting close to a significant fiscal boost for the region as a whole, on top of the ECB’s monetary boost. We may well be approaching a lasting resolution to the eurozone crisis.

This all creates an extraordinary opportunity for investing in the eurozone. Consensus expectations remain framed by fears of a euro crisis and valuations are low. So low, in fact, that on one calculation, current share prices can be justified only if you accept the notion that half of European companies will suffer declining returns on capital employed in perpetuity, a clearly absurd assumption. The average domestically orientated European company trades at a 50% discount to its US counterpart.1

Frontline reality

While the market remains anxious about the possibility of Europe sliding into deflation, the reality appears very different to this ‘stock-picker’ who is constantly in contact with companies, across many different industries, and right across the whole region. Strikingly, the tone of our meetings with company executives has been generally more positive than even we might have anticipated.

From Milan-based media group Mediaset, for example, we learn that Italian advertising spend is recovering. Among the continent’s telecoms companies we can note a rising optimism that price pressure should begin to ease in the future. Spain’s construction companies tell us that house prices are now rising for the first time in six years; the Spanish economy could grow by some 3% next year.1

Credit conditions are improving across the region. QE and other monetary operations are bearing down on bank funding costs, most notably in Europe’s periphery. The growth in money supply appears to be gathering momentum, with a recent ECB survey of bank lending showing the strongest pick-up in credit demand since 2007. The results of the Asset Quality Review suggest that the financial system is better capitalised than many had thought.

Finally, the recent sharp fall of 15% in the value of the euro relative to the US dollar should significantly improve the competitive position of the many international companies based in the region. Meanwhile the even steeper fall in the oil price will likewise help: oil at $50 a barrel probably adds 0.5% to 1% to annual European economic growth.

False consensus

The consensus remains that the outlook for Europe is dire. We disagree. This is not the beginning of the end. It is the end of the beginning. We remain committed to more Europe-centred, domestically oriented companies, which now constitute almost two-thirds of our investments; while companies from the European periphery – that object of consensus-investor concern – now represent nearly a quarter of our holdings.

Stuart Mitchell is the founder and chief investment officer of S. W. Mitchell Capital. For St. James’s Place, he manages the Continental European fund and is joint manager of the Greater European fund and Greater European Progressive Unit Trust.

1 S. W. Mitchell Capital equity research, January 2015

The opinions expressed are those of Stuart Mitchell and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research of advice. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.

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